The 'Best' Debt Payoff Strategy May Be Costing You

There is an ongoing debate as to the best debt payoff strategy. Some argue that you should pay off debt with the highest interest first. Others say you should disperse your payments, and pay the same amount to each, chipping away little by little. And finally, there is the idea that you should tackle the smallest debts first, knock them out completely, and then move on to the second smallest, and so on. This plays more to morale than financial savviness, but is still valid when debt is the leading cause of stress in American households, impacting younger generations, parents and lower-income families the most.

If you’re deciding where to start in terms of debt repayment, I’m of the opinion that you should prioritize credit card debt, because credit cards carry notoriously high interest rates. But what if you have debt spread over multiple credit cards?

The Harvard Business Review and HelloWallet sought to find what the best payoff method is when tackling credit card debt. Though their hypotheses were specifically tested on those paying off credit card debt, I think the results provide learnings that could easily be applied to those paying off several student loans of varying amounts and interest rates. The data examined 6,000 HelloWallet clients, and their spending, payments and credit card balances over three years. In looking at the information collected, the Harvard Business Review found “consumers who concentrated their repayments on one of their several accounts paid down more of their card debt than those who dispersed their repayments equally across multiple accounts.”

In other words, focusing on one debt at a time, paying it off and then moving on proved more successful than putting equal sums of money toward each credit card bill. Harvard Business Review took the study a few steps further, and determined two crucial things: first, those who pay off their credit card bills one at a time repaid them 15% faster than those who paid off the debt by putting equal sums toward each account. And second, that it really is easier to get rid of the smallest debts first.

After more experimentation, they reported on why consumers have an easier time paying off the smaller debts. It is related to “what portion of the balance they succeed in paying off.” Therefore, when focusing on the smallest bill, people are more apt to feel like they are making substantial progress. If you have $200 to put toward debt each month, putting it toward a $1,000 credit card balance shows you that you’ve already paid off 20% of your bill (not including interest). Putting $200 toward a $7,000 credit card bill is not as gratifying.

Here's the catch: paying off the smallest debts first is arguably the less financially savvy move. If you have a $1,000 on a credit card with 14% interest, and $5,000 on a credit card accruing 18% interest, then paying off the $5,000 bill makes the most financial sense. At that point, even putting a small amount toward each bill makes more sense than focusing on the smallest one. In the time you’re taking to pay off the $1,000 bill, the $5,000 will be growing with a 18% interest rate and the minimum payments will not even be making a dent on that. And yet, the snowball method, which is the principle of paying off the smallest debts first regardless of interest, has brought a lot of success, both for those paying off credit card debt, and those trying to rid themselves of student loans.

The snowball method was made popular by Dave Ramsey and requires you to only pay the minimum to all of your debts except the smallest. Then you focus completely on the smallest debt, and once you’ve paid it off, you use the momentum to pay off the next smallest, essentially paying up the line on your debts.

The opposite of this plan would be the avalanche debt payoff method, which focuses on paying the debt with the highest interest first, and working your way down the line.

Those who are pro-avalanche method — the snowball opposition party, that is — remind us that paying the smallest debts first might be costing you money. Magnify Money examined one couple’s finances, and did the math out to see how long it would take them to become debt-free using the snowball method versus the avalanche method. With the snowball method, the couple ends up paying $2,000 more in interest fees.

The moral of the story: Morale costs money when paying off debt, but it’s a crucial motivator. And according to the Harvard Business Review’s study, at least when focusing on credit card debt, morale might be worth more.